Creating Value

In the above diagram Q_1, Q₂ and Q₃ are the isoquants showing three different levels of output – 10units, 25units and 50units respectively. Product lines OA and OB show the relationship between inputs and outputs. The movement from point a to b indicates the increment of combination of inputs (labor and capital) from 1K+1L to 2K+2L. The movement also shows the increment in output from 10units to 25units. This shows that when inputs are increased by double the output increases by more than double, which explains the concept of increasing returns to scale. The case is same in the case of movement from point b to c as well.

REASONS FOR INCREASING RETURNS TO SCALE:

The increasing returns to scale is possible because of “economies of scale”. The possible economies to scale are;

HIGHER DEGREE OF SPECIALIZTION:

Due to increase in number of inputs, for e.g. labor and machines, higher degree of specialization of both labor and managerial cadre is possible. The use of specialized labor and management helps in increasing productivity per units of inputs by utilizing their cumulative efforts and thus contributes in increasing returns to scale.

TECHNICAL AND MANAGERIAL INDIVISIBILIIES:

Most of the machines and equipments can be better used only in certain range of output. Such inputs, used in production process are given in a definite size and which cannot be divided into small parts to suit small scale productions. For example, half a turbine cannot be used, a part of locomotive machine cannot be used and similarly, half of a manager cannot be employed. Because of the indivisibility of these inputs, they have to be employed in a minimum quantity even if scale of production is much less than their capacity output. Therefore when scale of production is increased by increasing all inputs, the productivity of indivisible factor increases exponentially, this results in increasing returns to scale.

DIMENSIONAL RELATIONS:

In some cases, due to increased dimensions, output rises faster than inputs, which leads to increasing returns to scale. For instance let us consider an example of a tank manufacturer. When he uses 6 metal plates of 1 square feet each, he can produce a water tank of capacity 1 cubic feet. But when he uses 6 metal plates of 2 cubic feet each he can produce a water tank of capacity 8 cubic feet. In this example when inputs are doubled the output is 8 times, i.e. the concept of increasing returns to scale prevails in this example.

MARKETING ECONOMIES:

The greater requirements of inputs and the corresponding increase of outputs lead to various marketing economies. For e.g. when raw materials are purchased in bulk, the purchaser can purchase them at a cheaper price. Similarly suppliers also favor the bulk purchaser and the good quality raw materials are delivered timely. These factors finally help to increase output fast.

RISK BEARING ECONOMIES:

Big producers can bear more business risks than small producers. With increase in scale of inputs and outputs, risk bearing capacity also increases. Big firms can plan and diversify products and markets fast that are helpful to raise output fast.